Monetary Policy Transmission in an Emerging Economy: The Key Role of Credibility Regimes

This paper investigates the effects of the Brazilian Central Bank (BCB) credibility on the outcomes of its monetary policy. In this sense, we seek to characterize periods in which the central bank can be categorized as strong (high credibility) or weak (low credibility) through a VAR methodology with an endogenously estimated threshold parameter. The econometric model includes the credibility variable, which defines the regimes, along with the output gap, inflation, 12 months ahead inflation expectations, the policy interest rate, and a long-term interest rate. Our dataset spans from 2003 to 2022, with monthly data. The estimations suggest a significant threshold parameter at 1%, with a value of 1.75 percentage points. Thus, we highlight that the BCB operates in a low credibility regime when inflation expectations exceed the tolerance bands around the inflation target. In fact, this occurred in 19% of the considered sample, equivalent to 46 months. Despite the relatively low frequency of periods in which the Brazilian Central Bank operated in a low credibility context, such a regime should be diligently avoided, as our evidence demonstrates that this regime is associated with a substantial reduction in the effectiveness of monetary policy in the country. We show, for example, that with low credibility, the BCB practically loses the ability to affect productive activity and the dynamics of prices (inflation and inflation expectations). When examining the possible causes of the reduction in the effectiveness of monetary policy conditional on the credibility regimes, we show that this variable can affect the existing trade-off between output and inflation in the economy. In other words, our results suggest that credibility regimes can influence the observed inclinations in the country's Phillips curve. Specifically, we point out that in a low credibility regime, inflation shocks generate recessionary effects on output, and inflation becomes more responsive to increases in inflation expectations, thereby reducing the degree of price rigidity. In conclusion, monetary policy in Brazil has effects that systematically depend on the credibility regime in operation. Therefore, maintaining a high credibility regime should remain a priority for the BCB, as it facilitates the achievement of favorable outcomes, including meeting inflation targets.